ANALYSIS OF DEEP COVERAGE MORTGAGE INSURANCE

Milliman Client Report

ANALYSIS OF DEEP COVERAGE MORTGAGE INSURANCE

Prepared for:

U.S. Mortgage Insurers

Prepared by: Milliman, Inc. Kenneth A. Bjurstrom Principal and Financial Consultant Jonathan B. Glowacki, FSA, CERA, MAAA Consulting Actuary Michael E. Jacobson Financial Consultant Madeline H. Johnson-Oler, CMB Executive Financial Consultant Michael C. Schmitz, FCAS, MAAA Principal and Consulting Actuary October 15, 2015

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ANALYSIS OF DEEP COVERAGE MORTGAGE INSURANCE

Prepared for:

U.S. Mortgage Insurers

TABLE OF CONTENTS

Section

Page

A. BACKGROUND AND SCOPE

A.1 Background .....................................................................................................................................1 A.2 Scope ..............................................................................................................................................1

B. EXECUTIVE SUMMARY

B.1 Deep Coverage Mortgage Insurance ..............................................................................................3 B.2 Analysis Results ..............................................................................................................................4

C. MILLIMAN'S ANALYSIS & ASSUMPTIONS

C.1 Mortgage Performance Model ........................................................................................................9 C.2 Deep Coverage Mortgage Insurance............................................................................................17 C.3 Pro-Forma Cash Flow Model ........................................................................................................18 C.4 Portfolio Assumptions ...................................................................................................................20 C.5 Scenario Analysis .........................................................................................................................21 C.6 Estimation of Borrower Impact with Deep Coverage Mortgage Insurance...................................22

D. QUALIFICATIONS AND LIMITATIONS; LIMITED DISTRIBUTION OF RESULTS

D.1 Qualifications and Limitations .......................................................................................................25 D.2 Disclosures....................................................................................................................................26 D.3 Limited Distribution of Results ......................................................................................................26

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A. BACKGROUND AND SCOPE

A.1 Background

U.S. Mortgage Insurers (USMI)1 is proposing to the Federal Housing Finance Agency (FHFA) that Fannie Mae and Freddie Mac (Government-Sponsored Enterprises or GSEs) could further meet the 2015 (and future) Conservatorship Scorecard requirements related to risk-sharing by substituting a portion of the current guarantee fee (G-Fee) requirements with a greater or deeper coverage mortgage insurance option. The GSEs provide a guarantee for credit risk on mortgages originated by approved lenders for inclusion in MBS Securities. In exchange for this credit risk guarantee, lenders pay a G-Fee. The components of the G-Fee include a projected cost for expected credit losses, administrative expenses and other fees, and a return on capital.

The GSEs' current charter2 requires that a credit enhancement, such as mortgage insurance, must be in place for any loans with less than a 20% down payment at origination. It is common practice for the GSEs to lower their exposure to credit losses for 85% loan-to-value (LTV) mortgage loans to approximately 75% LTV, 90% or 95% LTV mortgage loans to approximately 67% LTV and 97% LTV mortgage loans to approximately 63% LTV with private mortgage insurance. USMI's proposal would lower the GSEs' exposure to credit losses to approximately 50% LTV at origination by leveraging the existing mortgage insurance marketplace framework.

Mortgage insurance (MI) is a first layer of credit protection for investors. Mortgage guaranty insurers disperse and pool mortgage default risk by diverting accumulated premium revenues derived from relatively strong mortgage markets to cover losses in relatively weak mortgage markets. Default risk is dispersed and pooled both geographically and temporally. At the geographic level, insurers achieve diversification by writing business nationally, thereby better enabling them to withstand severe regional economic downturns. At the temporal level, insurers are subject to stringent minimum surplus and reserve requirements imposed by state insurance regulators and the GSEs. The contingency reserve and capital requirements generally cause insurers to retain premiums earned during periods of economic expansion in order to cover losses incurred during periods of protracted economic recession.

The premise of increasing private capital by utilizing deep coverage mortgage insurance coverage and reducing risk exposure to the GSEs is the focus of this analysis. Using publicly available historical mortgage performance data, this report highlights the potential loss protection to the GSEs and estimates the cost of and potential impact of mortgage insurers providing deep coverage.

A.2 Scope

Milliman, Inc. (Milliman) was retained by USMI to independently estimate the additional premium for private mortgage insurance that would generate a given return on capital assuming the extension of mortgage insurance coverage to a larger portion of the loan amount, referred to as deep coverage. The deep coverage mortgage insurance was assumed to reduce the GSEs' exposure to credit losses to less than 50% LTV

1 U.S. Mortgage Insurers (USMI) is a trade association composed of the following private mortgage insurance companies: Arch Mortgage Insurance Company, Essent Guaranty, Inc., Genworth Financial, Mortgage Guaranty Insurance Corporation, National Mortgage Insurance Corporation, and Radian Guaranty Inc.

2 "No such purchase of a conventional mortgage secured by a property comprising one- to four-family dwelling units shall be made if the outstanding principal balance of the mortgage at the time of purchase exceeds 80 per centum of the value of the property securing the mortgage, unless (A) the seller retains a participation of not less than 10 per centum in the mortgage; (B) for such period and under such circumstances as the corporation may require, the seller agrees Conventional Mortgages Credit Enhancement to repurchase or replace the mortgage upon demand of the corporation in the event that the mortgage is in default; or (C) that portion of the unpaid principal balance of the mortgage which is in excess of such 80 per centum is guaranteed or insured by a qualified insurer as determined by the corporation." Source: Federal National Mortgage Association Charter Act, Title II of National Housing Act, 12 U.S.C. 1716 et seq., As amended through July 21, 2010.

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utilizing the current mortgage insurance master policy requirements3. In addition, Milliman was asked to utilize publicly available information to estimate whether the cost of substituting deep coverage mortgage insurance would have an economic impact to the average borrower compared with G-Fees currently charged by the GSEs. To perform the analysis, Milliman utilized publicly available GSE loan performance data to calibrate a loanlevel regression model to estimate incremental losses that would be incurred by mortgage insurers providing the deep coverage mortgage insurance. The loan performance data supplied directly by the GSEs includes loan origination information and performance records for a population of mortgages that were purchased or guaranteed from 1999 through 2014. This information has been specifically released to better understand the credit performance of GSE mortgage loans and to support their recent risk-sharing programs. Although the data released includes only a subset of the GSEs' total historical mortgage purchases, the fully amortizing, full documentation, single-family, conventional fixed-rate mortgages included in the data is described as more reflective of their current underwriting guidelines and is therefore useful for illustrative purposes. In addition, Milliman utilized information supplied by the FHFA with respect to their June 5, 2014 request for input on Fannie Mae and Freddie Mac Guarantee Fees. Although detailed information about the GSEs' expected and unexpected credit losses that require G-Fee support is somewhat limited, a general framework for their construction was available and utilized by Milliman to evaluate the comparative value for the application of USMI's deep coverage mortgage insurance proposition. This report presents the results of Milliman's analysis. Note that Milliman's analysis is subject to Qualifications and Limitations as well as Limitations on Distribution of Results as stipulated in section D of this report. As described in that section, the analysis has been prepared solely for the use of U.S. Mortgage Insurers and cannot be provided to any other party without Milliman's prior written consent. In addition, the analysis is subject to the significant uncertainty inherent in mortgage insurance. These matters are discussed more fully in section D below.

3 Of note is a mortgage insurer's adherence to the Homeowners Protection Act (HOPA) that generally requires that mortgage insurance will automatically terminate on the date the mortgage loan balance is first scheduled to reach 78% of the original value.

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B. EXECUTIVE SUMMARY

Mortgage loan financing is a process with defined standards and qualifications for loan product, borrower underwriting and property considerations. In the aftermath of the housing crisis and with the implementation of new legislation for mortgage loan standards, the mortgage industry has adapted new compliance requirements and has re-evaluated the costs associated with mortgage credit default risk. These costs are paid by the borrower and are included in the cost of the mortgage loan interest rate. Borrowers that do not have 20% of the cost of the home as a down payment must pay additional fees to compensate for the risk of default. These fees generally include the cost of private mortgage insurance and the cost of credit risk default as defined by the primary investors in the conventional loan market, Fannie Mae and Freddie Mac.

The GSEs provide credit risk guarantees on the loans in the securities they issue. This means that the risk of loss from borrowers not paying their mortgage payments is borne by each GSE as they guarantee the timely payment of principal and interest to investors. In exchange for this credit guarantee, the GSEs charge a fee to the lenders and issuers of the securities they guarantee. Each GSE has an internal model that provides estimated costs for three components4 of G-Fees: expected losses for the loans they guarantee, administrative expenses, and a cost of capital. The GSEs do not specifically publish their model(s) and/or methodology for the determination of their expected losses, expenses and cost of capital and therefore it is somewhat difficult to replicate and project forward. With that said, Milliman has attempted to use publicly available information to estimate the various components of the applicable G-Fee and supplemented with Milliman's model estimated proportion of required retained expected and unexpected loss costs as necessary.

B.1 Deep Coverage Mortgage Insurance

Deep coverage mortgage insurance is defined as a traditional primary mortgage insurance company (MI) reducing a GSE's loss exposure for each mortgage loan down to 50% LTV from its traditional standard coverage. All existing primary mortgage insurance business attributes have been assumed to remain the same (such as traditional lender distribution, HOPA provisions for mortgage insurance cancellation, and current master policy provisions).

LTV

85% 90% 95% 97%

DEEP COVERAGE MORTGAGE INSURANCE Coverage and Exposures Compared to Standard Coverage

Standard Coverage

Deep Coverage

Coverage Percentage

Exposure Down-To

Coverage Percentage

Exposure Down-To1

12.0%

74.8%

41.2%

50.0%

25.0%

67.5%

44.4%

50.0%

30.0%

66.5%

47.4%

50.0%

35.0%

63.1%

48.5%

50.0%

1 Of note is a mortgage insurer's adherence to the HOPA that generally requires that mortgage insurance will automatically terminate on the date the mortgage loan balance is first scheduled to reach 78% of the original

home value.

As illustrated in the table above and graphically on Exhibit 1, deep coverage mortgage insurance would

reduce the GSE's exposure to credit related losses for a mortgage loan. For example, with a 10% down payment, a GSE's exposure would be reduced to 50.0% from 67.5% by increasing the mortgage insurance coverage from 25.0% to 44.4% (i.e., 90% - 0.444 x 90% = 50%).

4 The GSEs must also collect and remit to Treasury a 10 basis point (bp) fee to cover Payroll Taxes under the Temporary Payroll Tax Cut Continuation Act of 2011 (TCCA). This fee is charged to borrowers as part of the total G-Fee.

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